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Answer any EIGHT of the questions below. Most questions may be answered in one-half page. No answers should exceed one page. Exam is due August 26.

Financial Ratios, Cost of Capital and Market Efficiency

Please read the article on Changes in Lease Accounting. This is probably the single most substantial change in accounting policies in the last two decades. It takes effect next year. Please look at the Walgreens Annual Report from last year (08.31.2018). Page 2 of the PDF is a general summary of some important numbers, followed by the Balance Sheet, Income Statement and Statement of Cash Flows. The next page shows a page from their published Notes, and you can see the “Operating Leases” are $31 Billion. There is no asterisk (“ * “) so you know it is not on the Balance Sheet. You can also see this since the large $$$$ of Operating Leases exceeds the long-term liabilities shown on the balance Sheet ($12.4BB of Long-Term Debt and $5.5BB of other long-term liabilities). We know that these liabilities are going “on the balance sheet” as is the corresponding

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intangible asset called “right to use the stores”. Each will get written down (amortized each year). The most recent 10-Q quarterly SEC statements show that as recently as this quarter, these Leases are still not on the

Balance Sheet. Nonetheless, we know that this accounting change is coming… and is clearly described in their annual report, summary of accounting policies, and in general media and financial reports.

You took this class, but you help run the marketing department of Walgreens. You and your boss have lots of stock options in your employer (Walgreens). Your boss asks you three questions since they never took a finance or accounting class:

Question 1: What happens to financial ratios for the firm?

Question 2: What happens to the Cost of Capital since you are looking at a project that will take that into account?

Question 3: What happens to the value of your stock since you will e retiring in 20 years and really care about how the market values the firm.

Question 4: Impact of Negative Interest Rates for Capital Decisions

You are on the Board of Directors of a Publicly Traded Corporation. You also pride yourself on thinking at “30,000 feet” and looking at the big picture for the firm… taking into account benefits and results, as well as risks. The CFO explains that the new factory being considered (which will cost $70,000,000 to build and staff) looks more promising since the NPV of the project has increased… and it will almost certainly add Economic Value (positive EVA) for the firm. The reason the NPV has increased according to the CFO’s projections is that the discount rate is being reduced since the WACC for the firm has fallen… all because interest rates in the economy have really declined recently. As of today, nothing else has changed for the firm, and the firm’s historical risks (or correlation with the market) have not changed. This is change in the overall Yield Curve.

Read one or both articles from last month’s Bloomberg called Negative Rates – Bonds that Eat Your Money or Low Rates Change Everything. You agree with the CFO’s analysis of NPV from a formulaic sense. However, what are your thoughts for the rest of the Board when giving your commentary from 30,000 feet?

Question 5: Brexit and the Value of your Future Consulting Contract in London

You work for UGSCC (UConn Graduate Student Consulting Corporation) and have a two-year consulting contract in London which will be paying you in Pounds (Sterling) at the rate of 500,000 pounds every 6 months, starting 6 months from now (so approx. Feb’ of 2020). You and your team live in the United States and all your living expenses are here, in dollars. Your partner thinks that Brexit may influence the value of your payments once converted into dollars, and of course, nobody is sure (definitively) if it will be good or bad.

Your partner asks “how hedging works”… not whether you should definitely do it, or whether it will create a definite cost or benefit, but how would it work. What do you tell your partner? Is it definitively a good or bad idea if you consider yourself risk-adverse? Please see the “British Pound – U.S. Dollar Foreign Currency Futures”. The last page shows the 12-month trend and the current (spot) price of $1.20 for 1 Pound. Please note that since printed on a Saturday (08.10.19), most futures prices are “missing”. However, if you look at the right-hand column, you can see the last trade price from Friday the 9th, and that is certainly close enough.

Question 6: Executive Stock Options Create a Loss, But were Foreseen, Stock Tanks – Is the Market Efficient for Stocks Not Paying a Dividend

Please see the two articles about Uber, which were in the news this last week. Nothing new here… The larger Uber’s revenue, the larger their loss. They still have not reached critical scale to have positive EBITDA and their profit margin (or loss rate) is not getting better as they grow. Moreover, the stock options they gave employees and long-time drivers as part of the IPO were recorded as a compensation expense (as they should have). Much of the above was foreseen and well known when the Company did its IPO. We also know that Uber does not 9crrently) pay a dividend as it is reinvesting in its business – not returning capital to shareholders through buybacks or capital gains.

Was the market efficient with respect to Uber’s IPO or did the circumstances of the firm radically change in a way which could not be foreseen by “rational” investors?

Question 7: Bonds.

Look at the Morningstar printouts on the four bonds (“Bond Data”). All Bonds mature at roughly the same time. Some information is circled with notations to help explain what is meant. Remember that all Bonds “scale” to $1,000… so, $101 for a market price really means $1,010 (or 101% of face value). Use only the information on these pages which was printed on 08.10.2019. Therefore, you are making your decision on that date, after trading finished for the week. Which Bond would you buy, and why? Please tell us the framework for your investing decision (i.e., “I run a $50BB pension fund which has well diversified bond

portfolio” , or “this is my very first bon in my personal portfolio”, or “this is in my retirement account so I don’t care about taxes”, etc.). Second part of the question (a bit of nuance):  list a risk component (characteristic) for at least 2 of the bonds besides credit rating (risk of default). “Short and sweet” here… you could write a dissertation… just give us one or two. Finance is the exchange cash flows for risks, and we ask this second part of the question to remind you that there are many components of risk.

Question 8: Working Capital & a Merger in Animal Health

Please see the enclosed article on the forthcoming Merger (“Elanco and Bayer Animal Health Units”). Elanco is almost a “pure play” in animal health whereas for Bayer, it is a more modest proportion of their revenue.

This article (and news) became public in mid-July. Since then, Bayer stock is “up”, and Elanco is down… but this may be totally uncorrelated to the merger announcement (particularly for Bayer which is a huge company with many lines of business). Ignore all background information Bayer’s Debt, etc. You have just been assigned to a team comprised of professionals drawn from both companies to help create Economic Value for the new entity by improving the working capital at the new entity once the deal goes through. Do not consider human resources (cost reductions through layoffs)… Let us stick to the ways we can improve working

capital in a way that all shareholders and employees win at the (what will be) new company. Give three specific recommendations that you would like your “Working Capital Improvement Team” to consider?

Question 9: Evaluating Merger in Animal Health Shareholders and Managers

As for Question 8, please refer to the enclosed article on the forthcoming Merger (“Elanco and Bayer Animal Health Units”). Based on the criteria we set forth for beneficial mergers, do you believe this is a good merger? More specifically, do you believe that either group of shareholders will benefit from this merger?

Question 10: Mergers, Options and Compensation in Animal Health

As for the previous question Please refer to the enclosed file enclosed article on the forthcoming Merger (“Elanco and Bayer Animal Health Units”). Also refer to the file “Compensation Table from Elanco Proxy 2019 DEF 14A.” Managers are typically compensated with Stock, Options, Salary and Bonus. Consider the factors that affect the value of all these forms of compensation. Which forms of compensation will benefit from the merger and which forms will not? In particular, consider the options of the managers. Keep, the options will not be vested for a number of years and they are typically issued at-the-money.

Question 11: NPV

Elanco Animal Health made an offer for Aratana Therapeutics. Below I give numbers extracted (and simplified) from the Form 8-K filing, which Elanco sent to shareholders to determine the value of Aratana. In addition to the numbers given below, assume that all cash flows after 2025 will grow by 3% per year forever. Also, assume a discount rate of 10% for all cash flows.

Based upon these numbers what is the NPV of Aratana? If Aratana has 40 million shares outstanding, what is the maximum price per share that Elanco should be willing to pay to Aratana shareholders?

($ in millions) 2019 2020 2021 2022 2023 2024 2025
Revenue 32.2 49 85.2 73.2 99.6 117.9 144.1
Gross Profit 16.3 29.8 61.5 42.4 57.9 68.3 83.2
Operating Expenses 42.7 44.7 44.8 45 44.7 44.3 46.2
EBIT -26.4 -14.9 16.7 -2.6 13.2 24 37
Depreciation and Amortization 0.9 0.8 0.9 1 1.3 1.5 1.8
Capital Expenditures 0 5 5 -3 -3 -3 -3
Change in Net Working Capital 9.6 -6.6 -29.1 27.4 -5.4 -3.8 -5.3

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